I get a lot of questions, both during and after the tax-filing season, and I come across a lot of misconceptions among clients, about basic tax issues. During the next few months I would like to address some of these basic issues in this weblog. Today I want to talk about mutual fund investments.
Mutual funds make three types of distributions - ordinary dividends and capital gain distributions, which are paid out of the income of the fund, and, on occasion, a "return of capital", which is paid out of "principal".
Ordinary dividends and short-term capital gain distributions are generally (subject to the income threshold) reported on Part II of Schedule B and, prior to tax year 2003, have been taxed as "ordinary income" at the taxpayer's normal tax rate. Beginning in 2003 certain mutual fund “ordinary dividends” are considered to be “qualified dividends” and taxed at capital gain rates.
Long-term capital gain distributions are treated the same as long-term capital gains from the sale or exchange of investments. They are reported on Schedule D and taxed at the appropriate lower capital gains rate.
A distribution classified as "return of capital" is, in effect, giving back to you part of the purchase price of the fund shares, and is not taxable.
Distributions from mutual funds are taxable even if you do not actually receive the cash in your hands. Many investors elect to have some or all of the distributions reinvested in the fund. Reinvested distributions are treated as if you received a cash distribution from the fund and then turned around and used the cash to purchase additional shares in the fund, and, unless they represent a "return of capital", are fully taxable.
Dividends from a mutual fund that represent income from a direct obligation of the United States government, while fully taxable on your federal return, may be exempt from state income taxes. Such is the case in New Jersey. The mutual fund will usually send you a statement or notice in January that indicates what % of ordinary dividends are from US government obligations.
Since reinvested dividends are actually additional purchases of fund shares, they are added to the "cost basis" of your investment. Dividends reinvested over the years are added to your initial investment and any subsequent purchases and will decrease your taxable gain, or increase your deductible loss, when you sell the fund.
Let's say you invested $1,000.00 in the Flach Mutual Fund (there is no such thing) in 1995, and elected to have all distributions reinvested. Between 1995 and 2002 you received $700.00 in taxable distributions, which were reinvested in the fund. At the end of 2002 you sell all your shares in the fund for $1,200.00. You have a $500.00 long-term capital loss ($1,000.00 + $700.00 = $1,700.00 = $1,200.00 = $500.00).
Since distributions that are a "return of capital" represent a refund of your purchase price, they are subtracted from your "cost basis" when determining the gain or loss on the sale.
If you sell less than your entire investment in a mutual fund (i.e. you own 1,000 shares of the Flach Mutual Fund and sell 400 shares) there are four (4) methods available to you to determine the "cost basis" of the shares sold. These four methods are:
1. First-In, First-Out
2. Average Cost
3. Double Category
4. Specific Shares
You can elect to use the method that will provide you with the least amount of gain or the greatest amount of loss. You can use different methods for sales of different mutual funds, but once you use a method for the sale of shares of a particular fund you must use the same method for all sales of that fund. If you use the Average Cost method to determine the cost basis for your first sale of Flach Mutual Fund shares, you must use the Average Cost method each time you sell shares of the Flach Mutual Fund.
The Form 1099-DIV you receive from the mutual fund in January identifies the amount of the various distributions for the year by category. Prior to 2003, it reported ordinary dividends (which includes short-term capital gain distributions), long-term capital gain distributions, long-term capital gain distributions resulting from property held for at least 5 years, and non-taxable distributions (return of capital), as well as any foreign tax withheld from the distributions.
For 2003, the Form 1099-DIV will have to report ordinary dividends taxed at the normal "ordinary income" rates, ordinary dividends taxed at the lower rates, pre-May 6 long-term capital gain distributions, post-May 5 long-term capital gain distributions, and non-taxable distributions. Not all dividends from mutual funds will be eligible for the lower 5% and 15% rates. “Ordinary dividends taxed at the lower rates” are referred to as “qualified dividends” on the Form 1099-DIV. And we no longer have to worry about “pre-May 6” and” post-May 5” long-term gain distributions – they were for tax year 2003 only. Beginning with 2006 the Form 1099-DIV also reported any “tax-exempt” dividends resulting from fund investments in tax-free mutual bonds.
You will receive a Form 1099-B to report the "gross proceeds" from any sales of shares in the mutual fund during the year. The mutual fund also sends a copy of both the 1099-DIV and 1099-B to the IRS.
The mutual fund may also send you an "Average Cost Statement" for the shares sold, generally using the Average Cost method. This Average Cost Statement is not sent to the IRS, but is for your information only. You do not have to use the cost basis reported on this statement to determine your gain or loss on the sale(s). You can use any of the four methods identified above, subject to the restriction I have discussed.
It is important that you give all 1099-DIVs, 1099-Bs and Average Cost Statements that you receive to your tax preparer, as well as any other year-end information, statement or notice that the mutual fund sends you.
It is also very important to save all purchase "confirmation" slips and account statements for the fund for as long as you own shares in the fund so that your tax preparer can properly calculate the appropriate cost basis when you sell the fund.
I hope you have found this posting helpful. If you have any questions about the tax treatment of mutual funds you can email me at email@example.com. Or you can submit your question as a “comment” below.